Plays on an expected rise in US interest rates ramp up

By Mike Kentz

March 28 (IFR) - Investment firms looking for the right time
and way to play an expected rise in US interest rates may have
found their trade.

Correlation across equities and rates are adding weight
behind widely-held beliefs that recent equity highs cannot be
maintained and a continued economic recovery will force a rate
rise. The confluence of these factors, as well as an expectation
that the Federal Reserve will slow down or exit quantitative
easing at some point this year, is creating an opportunity for
investment firms to purchase cross-asset options structures that
play all four assumptions.

The trades involve purchasing options on the S&P 500 that
only pay out if rates rise past a particular level before
maturity.

After mostly-vanilla rates options plays gathered pace in
the early part of the year, the contingent options structures
have been purchased by a host of funds over the past few weeks,
according to dealers.

"Strengthening US data is suggesting the Fed may move up its
time-line for withdrawing QE, and if the rollback is disorderly
it could be substantially negative for equities," said Mohamed
El-Hioum, co-head of the equities structuring group for the
Americas at Deutsche Bank. "The recovery has withdrawn some of
the deflationary pressure that allowed the Fed to freely
stimulate the economy, but has also raised the possibility of an
uncontrollable move once rates do start rising.

"As a result, rate-contingent S&P 500 put options have
emerged as the preferred way for hedge funds to get cheap
downside equity and upside rate exposure at the same time."

The trades, ranging in value between US$50m and US$500m
notional, pay off if the S&P drops below 95% of its current
level, contingent upon 10-year rates rising to levels between
2.7% and 3%.

NUMBER CRUNCHING

Data such as home prices and unemployment figures are the
core drivers. The home prices S&P Case-Shiller Index rose 8.1%
in January from a year ago, while unemployment in February
reached its lowest level since December 2008.

Those economic boosts drove the Dow Jones industrial Average
to end Tuesday's trading at a record high while the S&P 500
closed two points shy of an all-time high at 1,565.15.

"The writing is on the wall for most investors," said Bulent
Baygun, head of US interest rates strategy at BNP Paribas.

"Since the beginning of the year fixed income managers have
changed their duration bias to bearish, with an eye towards
higher rates, over the medium-term in view of improving US
economic fundamentals. The time-line of the rise in rates is the
big question, especially given the fact the asset purchase
program doesn't appear to be nearing its end."

One-year correlation across the S&P 500 and 10-year Treasury
yields is currently just above 50%, close to 2003's all-time
highs slightly north of 60%. Two of the last three times the
levels reached these heights, correlations subsequently tumbled
sharply, first in January 2003 and again in 2005.

"The high correlation between the S&P and Euro or between
the S&P and interest rates offers an opportunity to
significantly cheapen trades that take the view that these asset
pairs will diverge," said Michael Nadel, co-head of equities
structuring group for the Americas at Deutsche Bank. "It's
particularly attractive to sell correlation between these pairs
now, before the current regime unwinds."

The contingency factor can provide real savings but of
course adds risk. For example, a one year at-the-money put
option on S&P 500 costs approximately 7% of the notional. The
same put contingent to a 10-year rates rise from current 2.10%
levels to 2.9% at maturity would cost 1.35% of the notional;
80% less of the initial put premium.

"The entry point for these trades is good at the moment,"
said Ramon Verastegui, global head of engineering and strategy
at Societe Generale in the Americas. "As the Fed exits QE, we
expect significant rates increases, which can lead to a US
equity rally correction and a dollar strengthen over the
medium-term. You can combine those views in a cheap way that is
only augmented by the current dynamics of correlation that are
likely to correct."

Other funds have preferred to replace the rate contingency
with currency contingency, betting that the S&P will continue a
slow grind upwards, thus supporting the dollar and weakening the
euro. Those funds have picked up structures that pay out if the
euro dips below US$1.25.

"I tend to agree," said one hedge fund trader. "We could see
an environment where euro continues to grind down and the S&P
up. I could see that as a theme into the summer at least."

Six-month correlation between the euro and S&P 500 sat at
40% by mid-week last week, a long way from the 80% peak of
summer 2011, but above the median for the past decade.

FED THINKING SHIFT

Data points may force a rate rise with or without a QE exit,
but a slight shift in Fed thinking is adding to the
expectations.

The first indication that the Fed might be re-thinking its
stance came at the end of January, when FOMC members mentioned
QE concerns surrounding inflationary risks, the difficulty in
withdrawing such a large balance sheet from the market, and the
effects the asset purchasing program is having on participants'
ability to price risk.

The appearance of that discussion sent equities and gold
into free-fall at the time, as the comments provided momentum
for beliefs that the Fed will eventually realise the negative
aspects of QE and begin to unwind.